The recent loss by the IRS in the Tax Court case Wandry v. Com’r, T.C. Memo 2012-88, added to the string of defeats the IRS has suffered in formula clause disputes, and has effectively dealt a final blow to Procter v. Com’r, 142 F.2d 824 (4h Cir. 1944), a seminal case which held that formula clauses attempting to reallocate completed gifts operate as a condition subsequent and are void as against public policy. Even before Wandry, the IRS had been unable to stem the tide, losing cases in situations where defined value clauses were held effective in shifting to charity the overflow of gifts of partnership interests whose values had been upwardly revised by the IRS.

Wandry let open floodgates in approving the effective reallocation of assets to the transferor pursuant to a defined value clause in the transfer documents. The end result reached in Wandry is virtually indistinguishable from the result which the Fourth Circuit forbade in Proctor. The case has been appealed to Tenth Circuit.

[In Wandry, the taxpayer made gifts of family limited partnership interests to their children. The assignments and memorandums of gift used to effectuate the gifts each stated the gifts in dollar values of membership interests, and provided that in the event that “a final determination of a different value is made by the IRS or a court of law, the number of Units gifted shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above.” In other words, the petitioners used a defined valuation clause but without the familiar charitable overflow beneficiary. In 2004, the year of the gifts, the partnership capital accounts of the taxpayers’ were decreased, and the donees’ capital accounts were increased to reflect the gift. Likewise, the taxpayers’ gift tax returns for the year reported gifts in accordance with the values stated in the transaction documents, which values were corroborated by a valuation obtained by the taxpayers. In 2006, the IRS asserted a gift tax deficiency, claiming that partnership interests were undervalued. The IRS argued that (i) the schedules supporting the gift tax returns, which stated the exact percentage interests transferred, constituted admissions by petitioners that they had transferred fixed percentage interests; (ii) the partnership capital accounts were dispositive; and (iii) the adjustment clause created a condition subsequent to a completed transfer, thus violating Proctor’s prohibition against transfers that are void as against public policy. The Tax Court dismissed the first two arguments, stating that it was clear that the taxpayers intended to make gifts of specific values, not set partnership interests, and capital accounts do not control gifts when the gift documents used are unambiguous and gift tax returns are filed. The Tax Court then held that the adjustment clause should be respected, and therefore no additional gifts were made upon the later revaluation of the interests by the IRS.]

Wandry is significant for several reasons: First, it serves as yet another example of the diminishing importance of Proctor. Second, it reinforces the distinction between a reversion and a clause that simply defines a gift, clarifying that a clause defining a gift in dollar terms does not operate to take anything back in the event of a revaluation. Third, it provides a roadmap for the use of formula clauses, emphasizing the importance of expressing the gift consistently as a dollar value in all relevant documents. Fourth, and perhaps most importantly, it stated the previously evasive holding that it is “inconsequential that the adjustment clause reallocates membership units among petitioners and the donees rather than a charitable organization.”

Prelude to Formula Clauses

When it comes to value, the Internal Revenue Code applies a simple test: Something is worth what someone will pay for it. Treas. Reg. §20.2031-1(b). However, since this test ignores relatedness, transfers among family members have long been “subject to special scrutiny” by the IRS. Estate of Reynolds, 55 T.C. 172 (1970). The necessary inference is that a related buyer and seller, or donor and donee, will act collaboratively rather than independently in valuing a transferred asset. Complicating matters further, such transfers routinely involve interests in closely-held entities, such as limited partnerships, which are inherently hard to value. Therefore, a cornerstone of most properly executed gift and sale transactions among related parties is a professionally prepared valuation. The problem, of course, with using a valuation to determine the value of assets gifted or sold is that the IRS may challenge the valuation. If the IRS believes that the value placed on the transferred asset was too low, the Service could assert a gift or estate tax deficiency.

Illustration

To illustrate, assume wealthy taxpayer wishes to fully utilize his$5.12 milliongift and estate tax exemption before the exemption sunsets in January 2013. An expert appraises Park Avenue building owned by the taxpayer at $51.2 million. The taxpayer transfers a 10 percent interest in the building to his son in December of 2012. In April of 2013, the taxpayer files a gift tax return reporting a gift of $5.12 million. In January of 2016, the IRS, after audit, proposes a deficiency of $308,000, asserting that the building was worth $60 million at the time of the gift (i.e., a 35% gift tax on the additional $880,000 transferred). Had father used a defined value clause, he might have limited his tax exposure.

Defined Value Clauses

Defined value clauses are “formula” clauses used to prevent unintended gifts. They operate by defining the transfer in terms of a specific dollar amount of assets, rather than a percentage of the assets, and provide for an adjustment to the transfer if the IRS or a court later determines that the value the taxpayer ascribed to the transferred asset was incorrect. Using the example from above, had the father transferred “an interest in the building worth $5.12 million,” this would have “defined” the transfer in terms of value rather than partnership units. In the event the IRS determined that the building was worth more than $51.2 million, a sufficient quantum of the amount initially transferred to the son would be deemed not part of the original transfer, or, if provided for, reallocated to a nontaxable entity, thus resulting in no gift overage.

Evolution of the Case Law

Defined value clauses are effective valuation risk-reducing tools, which attorneys have been using for decades. However, the IRS has been hostile to formula clauses in general, and have long challenged their propriety. The case law addressing formula clauses in transfer documents spans nearly 70 years. The seminal case on formula clauses is Com’r v. Procter, 142 F.2d 824, 827 (4th Cir. 1944). In Procter, the donors assigned gifts of remainder interests in trusts to their children, but provided that “any excess property. . .decreed by the court to be subject to gift tax shall automatically be deemed not to be included in the conveyance.” This formula clause operated to cause a reversion to the grantor of property that would be subject to a gift tax. Although the taxpayer prevailed in Tax Court, the Fourth Circuit reversed, holding that the reversion was a condition subsequent to a completed gift, and therefore impermissible. The court also found that the clause was void as against public policy, because any attempt to collect tax would merely reverse the gift. Proctor referred to the savings clause as a “device,” and made clear that, no matter how fancy such a ““device” is, it cannot operate to cause the taxpayer to reacquire property that has been irrevocably gifted. Later attempts to undo completed gifts through savings-type clauses were also unsuccessful. See Ward v. Com’r, 87 T.C. 78 (1986). However, the lasting effect of Procter and its progeny was to spur an increase in the use of formula clauses designed to cap transfers without the use of a reversion, thus expressly avoiding the public policy objection underscored in Procter.

McCord v. Commissioner (2006)

In Succession of McCord v. Com’r, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003), donors gifted the majority of interests in a limited partnership to their sons, trusts for their issue, and to two charities. An “assignment agreement” provided that the sons and the trusts were to collectively receive partnership interests worth $6.9 million; any value in excess of $6.9 million was to be reallocated to the charities. The assignment agreement also permitted all three assignees to allocate among themselves their interests in the gifted property, and to purchase interests from each other at later agreed upon values. The later agreed upon values were memorialized in a “confirmation agreement.” The IRS assessed a deficiency and argued in Tax Court that the formula clause was void as against public policy under Procter.
The Tax Court focused on the values memorialized in the confirmation agreement, rather than the dollar value gifts articulated in the assignment agreement. Therefore, the IRS deficiency was sustained, since the values in the confirmation agreement resulted in a greater taxable gift than would have resulted if the dollar value of the gifts articulated in the assignment agreement were respected. The Fifth Circuit reversed and found for the taxpayer. The court first noted that a gift is valued on the date of the gift, and not by subsequent events. The court then found that the value of the assets was properly reported by the taxpayer. Therefore, the parties’ post-gift “confirmation agreement” was irrelevant to the determination of gift tax. In ruling on this issue, the Fifth Circuit left no doubt that it disapproved of the Tax Court’s rejection of the formula clause, and left the impression that defined value clauses are inherently proper. The Fifth Circuit admonished the Tax Court for its “palpable hostility” to the expression of a dollar value gift through a formula clause, and caustically remarked that “[r]egardless of how the transferred interest was described, it ha[d] an ascertainable value” on the date of the gift.
The formula clause apparently validated in McCord differed from the savings clause held void as against public policy in Procter in two significant ways: First, it defined the gift as a specific dollar amount, rather than as an interest which was to be redistributed in the event of a redetermination of value of the transferred asset; and second, it operated to cap the gift not by effectuating a reversion in the grantor, but by reallocating the interests among beneficiaries to accord with the stated dollar amount gifts made. The McCord formula clause was simply a defined value clause coupled with a reallocation provision.

Christiansen v. Commissioner (2008)

The next in the progeny of formula clause cases was Christiansen v. Com’r, 130 T.C. 1 (2008), aff’g 586 F.3d 1061 (8th Cir. 2009). In Christiansen, the decedent’s will left her entire estate to her daughter, but provided that 25 percent of any amount disclaimed by her daughter would pass to a charitable foundation. Following the decedent’s death, daughter disclaimed all amounts over $6.35 million “as finally determined for federal estate tax purposes.” On audit, the IRS challenged the value of the gross estate. The parties eventually settled on a increased value. That increased value increased the amount which passed to the charitable foundation under the formula clause. The estate claimed an additional deduction for the excess amount that passed to the charity. The IRS disagreed, arguing that since the valuation was finally determined after the death of the decedent, Treasury Regulation §20.2055-2(b)(1) barred the additional deduction sought by the taxpayer. The Commissioner also argued that the disclaimer clause was void as against public policy, since formula disclaimers which could provide no possibility of enhanced tax receipts eliminated the incentive of the IRS to audit.
The Tax Court rejected the Commissioner’s argument, and decided that the Estate was entitled to the increased deduction. In affirming, the Eighth Circuit held that the Treasury Regulation cited by the Commissioner “clear[ly] and unambigous[ly]” requires only the existence of a final transfer at the date of death, and not a final determination with respect to valuation. Applying the Regulation to the facts, the court found that all that remained uncertain at the decedent’s date of death was the value of the estate, and that “[t]he foundation’s right to receive twenty-five percent of that amount in excess of $6.35 million was certain.” As to the Commissioner’s policy argument, the Court was blunt, remarking that “the Commissioner’s role is to enforce the tax laws,” not merely maximize tax receipts. The Eighth Circuit went further, stating that “even if we were to find [such] a general congressional intent,” the Commissioner’s policy argument is based on the flawed premise that the Service’s “marginally decreased incentive to audit” would promote undervaluation of estate assets. In any event, proclaimed the Court, there are “countless other mechanisms,” such as state and federal laws, in place to ensure accurate reporting.
The formula clause in Christiansen was a disclaimer that operated precisely like a defined value clause. Christiansen only validated the efficacy of the clause itself, but diminished the application of Procter rationales often invoked by the IRS to attack formula clauses. The Christiansen court implied that those policy arguments are inapplicable when there is no reversionary component to the formula clause. Christiansenstood for the proposition first noted in McCord, i.e., that post-gift valuation disputes are irrelevant to the existence, or lack thereof, of a final transfer on the date of the gift.

Petter v. Commissioner (2011)

In Estate of Petter v. Com’r, T.C. Memo. 2009-280, aff’d, 653 F.3d 1012 (9th Cir. 2011), the IRS Commissioner again challenged formula clauses which defined transfers as dollar amounts “as finally determined for federal gift tax purposes.” The Tax Court in Petter approved the transactions and for the first time, using the prior case law as indicia, sanctioned the use of formula clauses in clear terms, noting that “[t]he distinction is between a donor who gives away a fixed set of rights with uncertain value – that’s Christiansen – and a donor who tries to take property back – that’s Procter . . . A shorthand for this distinction is that savings clauses are void, but formula clauses are fine.” Without so much as even addressing public policy, which argument was abandoned by the Commissioner on appeal, the Ninth Circuit affirmed. After a long evolutionary line of cases, Petter finally established the validity of formula transfer clauses, at least in the influential Ninth Circuit. However, the transfer documents in McCord, Christiansen, and Petter all had a common thread separate and apart from their use of a formula clause: The pour-over recipients of any value above the value transferred to the primary recipients flowed to charity. The type of defined value clauses used in those cases has become known as a “charitable lid,” and is now commonly used. However, one basic uncertainty remained: What if the overflow beneficiary is a non-charitable entity or the definition clause effectuates a redistribution of interests among the transferor and transferees? Wandry held this distinction to be “inconsequential.”

Conclusion

Since transfers among family members so often include interests in closely-held entities which are inherently difficult to value, attorneys should consider risk-reducing strategies when effectuating transfers of family assets. Case law now appears to firmly sanction the use of formula clauses designed with a pour-over gift to charities. For taxpayers not inclined to make charitable gifts, the use of a defined value formula clause, such as that in Wandry, may be considered. However, one must note that although the trend of case law is clearly moving in the direction of blessing in entirety formula clauses framed in terms of defined dollar values, no Courts of Appeal have completely rejected Proctor, nor have any ruled on the use of a defined value clause with no pour-over charitable beneficiary. Wandry\ is now being appealed to the Tenth Circuit. The aggressive use of defined value formula clauses without a charitable beneficiary may remain problematic until the Tenth Circuit has decided the appeal.

Compliance Considerations

The use of defined value clauses increases the administrative burden associated with a gift, since there exists a heightened importance of ensuring that the gift tax return is consistent with the transaction. Any gift tax return should express the gift as the specific dollar amount used in the defined value clause, and should reference the terms of the original gifting documents. It should be noted that an income tax corollary may also result from the use of defined value clauses. If the value of the gift is successfully adjusted upward by the IRS, and the defined value clause is respected, the interests owned by various persons or entities will also change. This may require amendments to income tax returns. The use of a grantor trust as the donee or purchaser could help to alleviate this problem.